Dow should sound alarm

Personal Finance

Beware euphoria

Don't forget lessons learned from market's run-up in 2000 when `sure bet' stocks went south

October 22, 2006|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

The Dow Jones industrial average ventured into new territory last week when it closed above 12,000, a reminder of those heady days nearly seven years ago.

Back then, market euphoria turned investing principles upside down. Diversification was declared dead. Technology was the only game worth playing.

Earnings, or even revenue, didn't matter. Neither did dividends. Stock appreciation was everything. Our tolerance for risk was off the charts.

And who needed professional advice when stocks only went up? A dart and the stock tables worked just as well. Everyone became a stock expert.

"My favorite was a client who said he got great stock tips from his personal trainer," said Bethesda financial planner Mary Malgoire.

Of course, we all know what happened in 2000. The dot-com bubble burst and stocks tanked. Plenty of pain was felt all around for years.

As the Dow hits new highs, it's a good time to reflect on the lessons of the last market run-up. Will they stick with us if the market catches fever again? Or are we doomed to repeat our mistakes?

A few investment experts say investors are more knowledgeable now, particularly those who had to postpone retirement because of investment losses.

"They are all focused now. They don't want to go through what they went through in 2000," said Morry A. Zolet, a senior vice president with Smith Barney in Lutherville.

If a client is even tempted to chase a hot stock, Zolet said all he has to say is, " `Remember 2000.' And people will put on the brakes."

But many others say investors are wired to repeat mistakes. And by the time the market wildly takes off again, there will be a new crop of investors who never experienced a downturn and learned from it.

"Sadly, history repeats itself," said John Sestina, a financial planner in Columbus, Ohio. "As Americans, we have a wonderful attitude that it will be better next time. That's what hurts."

Market conditions today aren't like before, experts point out. The rally is not limited to a single sector. Corporate profits are healthy. And the market upswing is being driven by institutions, such as pension funds, not small investors.

Stocks also aren't grossly overpriced as they once were.

The tech-laden Nasdaq composite index and the broader barometer, the S&P 500 index, both have a way to go before reaching old heights.

And, after factoring for inflation, the Dow itself has more than 2,000 points to go to surpass the record set on Jan. 14, 2000, according to the Center on Budget and Policy Priorities.

Still, if this upswing continues, consider these lessons from the past:

Diversification is key. "I was throwing my shoe at the television screen in 2000 listening to those guys on CNBC," said David Straus, senior portfolio manager for Johnston Lemon Asset Management Inc. in Washington.

"They were saying people shouldn't be in anything but tech. It was so shortsighted. Diversification is incredibly important."

This is probably the No. 1 lesson of the bear market. A well-rounded portfolio generally holds domestic and international stocks and bonds; shares in small-, medium- and large- companies; growth and value stocks; and real estate, experts said.

Ted Toal, an Annapolis financial planner, said investors with a diversified portfolio likely would have recovered any losses three years ago. Some of his new clients who hadn't been diversified are just now breaking even, he said. "And some still haven't broken even."

Asset allocation pays. Asset allocation is the percentage of your portfolio devoted to stocks, bonds and cash based on your risk tolerance and years to invest.

The closer you are to retiring or tapping the account, the smaller the percentage you should hold in stocks because of their volatility.

Once or twice a year, you should review your portfolio to make sure you asset allocation hasn't drifted too far off. A run-up in equities, for instance, could mean stocks make up 70 percent of your portfolio rather than 60 percent, as you intended.

When this happens, investors should "rebalance" their portfolio to return it to the original asset allocation. This means they will sell some of their winners, and put the proceeds in securities whose prices have fallen.

Dull, but it works. In the last run-up in the market, stocks quickly overtook portfolios. And without rebalancing, many investors ended up with huge positions in stocks with little protection when the market turned.

Dividends matter. Investors didn't care about dividends during in the 1990s.

Howard Silverblatt with Standard & Poor's said their attitude was: "Don't bother to send me a dividend. My stock is going up 20 percent. It's not worth the stamp."

But when stock prices no longer went up, investors gained new respect for dividends. Dividends and their reinvestment account for nearly 41 percent of the S&P 500's total return from 1926 through last month, Silverblatt said.